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Walking the Corporate Board Compensation Tightrope

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Walking the Corporate Board Compensation Tightrope Quarterly ISSUE THREE 2018 Walking the Corporate Board Compensation Tightrope By Priya Kapila How to effectively balance recognition and rewards with independent board governance. Common leadership principles regularly cry out against surrounding oneself with others who are too agreeable—the quintessential yes men and women. Such a team structure tends to lead to “group think,” diminished creativity and risk taking, pursuit of ideas without proper planning, and outside suspicion that leaders lack confidence, competence or worse. So what is the solution when yes men or women are in positions intended to serve as the company’s watchdogs? Following the financial crisis and the implementation of Dodd-Frank Act rules, boards of publicly traded firms had to be composed of knowledgeable, independent directors who can be responsible fiduciaries. However, for privately held companies—which represent the vast majority of American engineering and construction (E&C) firms—it is more common to have inside directors and less likely to have subject matter experts within defined board committees. These factors, combined with uncertainty over how to compensate directors, can lead to ineffective board leadership. Board Composition in the E&C Industry In the E&C industry, companies report having eight or nine board members, on average, regardless of ownership structure. Those numbers correlate with the company’s size; that is, the larger the organization, the more members on the board. Among privately held companies, there are generally more inside directors—often employees, employees’ relatives and others with a deeply vested stake in the business—in comparison to publicly traded firms. Exhibit 1 shows that inside directors are usually a majority in private construction firms (versus a clear minority within public companies). The primary U.S. securities exchanges require that a company’s independent directors make up a majority of the board. Because compliance with federal regulations is significantly Exhibit 1. Inside vs Outside Directors less for private companies, these E&C companies are fre- quently more relaxed in their board practices. For example: Private firms hold fewer meetings: an average of 46.2% 4.2 per year as compared to 5.6 in public firms. 73.1% Private firms are slightly less strict in requiring board attendance at meetings: 44% of privately held con- tractors have mandatory board meetings, while 50% 53.8% of publicly traded companies do. 26.9% Larger private firms report having established com- mittees, but do not necessarily follow the same Privately Held Publicly Traded rigor when creating committees or selecting mem- bers. For example, most privately held firms lack Inside Outside a nominating and corporate governance committee, and most do not have 100% independent audit and Source: FMI’s Executive Compensation Survey compensation committees (required for trading on the NYSE). Looser policies related to board and committee composition and meetings do not necessarily suggest that a com- pany is more at risk or that performance will diminish over time. Many closely owned firms, in which owners and family members are the sole board members, have been successful through multiple generations. However, there is increasing evidence to suggest that diversified board membership can enhance financial performance. Engineering and construction firms must weigh some critical factors when adding new outside directors to their boards—not the least of these is how best to compensate them. It is very unusual to provide compensation to inside directors for their board participation (as opposed to their employment with the company). FMI’s survey results show that fewer than 5% of contractors provide any compensation to inside directors. Outside director compensation must be competitive to attract well-qualified individuals. And to avoid questions of independence and reinforce responsible actions for the company’s benefit, that compensation must be reasonable. WALKING THE CORPORATE BOARD COMPENSATION TIGHTROPE | FMI QUARTERLY Q3 2018 2 Board Compensation: Fresh Insights Outside board member compensation may be composed of some mix of the following: Retainer. Fixed payments to directors as compensation for their services, annual retainers are provid- ed without regard to actual contribution or meeting attendance. There is a perpetual pendulum swing between annual retainers and meeting fees as the primary component of board compensation. While retainers tend to be more attractive to prospective board members, meeting fees more clearly convey the expectation that meetings be attended. Only one-third of large E&C companies (i.e., those reporting over $500 million in revenue) participat- ing in FMI’s Executive Compensation Survey pay an annual retainer to outside board members; the median retainer is approximately $62,000. Retainer amounts vary widely from company to company and are impacted by whether a firm is privately held or publicly traded, as shown in Exhibit 2. Not surprisingly, the median retainer among smaller companies is notably less, at approximately $20,000. Meeting Fees. “Pay for participation” is a common way to compensate board members for their atten- dance at board and committee meetings. These fees may be combined with a retainer or compose the only form of cash compensation to directors. Meeting fees encourage meeting attendance, but given the fiduciary responsibility that members are expected to uphold, attendance should be—and for many companies is—a requirement of the position. Additionally, premium fees are frequently paid for directors who serve as committee chairs. Committee chair premium fees are generally 25% to 50% of the standard meeting fee. Likewise, the board chair often earns a similar premium over the board meeting fee paid to other members if there is not a sep- arate retainer paid to the chair. As shown in Exhibit 3, there is relatively little variance across construction firms in meeting fee amounts, both for board meetings and committee meetings. Exhibit 2. Average Annual Retainer Paid Exhibit 3. Outside Director Meeting Fees $250,000 $6,000 $5,000 $200,000 $4,000 $150,000 $3,000 $100,000 $2,000 $50,000 $1,000 $0 $0 Privately held firms: Average $45,558 25th 50th 75th Publicly traded firms: Average $130,000 Percentile Percentile Percentile Board Meeting Committee Meeting Source: FMI’s Executive Compensation Survey Source: FMI’s Executive Compensation Survey WALKING THE CORPORATE BOARD COMPENSATION TIGHTROPE | FMI QUARTERLY Q3 2018 3 Perquisites. There was a time when directors regularly received health insurance coverage, participat- ed in supplemental retirement programs, were reimbursed for first-class travel, and were offered sub- sidies for outfitting offices and the like. These benefits are taxable, so many companies also provided additional compensation to board members to cover taxes. Perquisites have been largely eliminated in the face of greater regulatory and public scrutiny. Currently, most companies only cover board members for travel expenses to and from meetings. Incentive Compensation. Frequently paid on a discretionary basis, incentive compensation to outside directors is often reserved for annual bonuses, which tend to be quite small relative to total director compensation. This helps board members focus on the long-term trajectory of the company instead of short-term performance. When a company has a long-term incentive plan or similarly structured equity-based award plan, out- side directors are commonly included in the program. According to FMI’s survey results, nearly 40% of contractors offer long-term incentives to board members, which may be composed of cash, stock, synthetic equity or some combination thereof. The vesting period is often aligned with a regular board term—typically three to five years. In some instances, the grant of equity may support broader ownership guidelines. Only 18% of con- tractors currently require outside directors to have (or to work toward) a minimum level of ownership in the company, and it is a gradually increasing provision. The objective is much like the rationale behind providing equity or other long-term incentives to executives—to better align behaviors and interests with those of shareholders. For companies with formal ownership guidelines for outside board members, the most common requirement is that equity equal to three times annual compensation be accumulated within five years of being elected to the board. For companies that are not inclined to dilute ownership, the requirement may be satisfied through phantom stock or similar deferred com- pensation arrangements. Looking for a Consistent Board Compensation Approach One recent survey of private companies, of which slightly more than half were family-owned, reported that 95% had seen earnings increase since introducing formal boards. In the survey, boards were evenly split, on average, between inside and outside directors. The evidence of improved financial performance as well as better oversight for governance and compliance activities and additional expert guidance on operational matters are compelling reasons for a company to establish and maintain a board of directors. As companies diversify their boards and add outside directors, a consistent approach to board compensation becomes an imperative. A plan for compensating board members helps attract qualified individuals and encour- ages the desired fiduciary and advisory activities. To develop a board compensation program, the
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